An asset can be defined as anything in possession of a company or an individual which carries an exchange value. These have been categorised into being tangible and intangible.
Tangible assets: Tangible products are those which can be felt by the senses of an individual and has a physical form. These are holdings of an individual or corporation that are real, actual, and exist in physical form. These assets are held by the company with the hope of generation of future cash flows using them. Most tangible assets are easily convertible into cash or cash equivalents. These are used as collateral in case of borrowings by the owner. When the company is sold, real assets are considered to calculate the selling price. These are depreciated over the period of usage generally. Examples would include building, plant and equipment etc. An example of non-depreciable tangible asset is land.
Intangible assets: intangible assets rather represent the legal claim to future benefits. They do not exist in physical form and are only existent as a claim. They can be divided into two categories whereby the legal intangibles include intellectual property and the competitive intangibles include reputation for example. Examples of legal assets would include copyrights, patents, trademarks, brand names, and trade secrets. Similarly examples of competitive intangibles are human capital, reputation, leveraging and collaboration. These are not depreciated but are amortised.
Financial instruments are intangible assets.
Issuer: the party which has committed to make future cash payments.
Investor: the owner of the financial instrument.
Classification on the basis of the type of claim
Debt Instrument: these are the financial instruments where the owner has claim to a fixed amount.
Equity Instrument: these are the financial instrument where the owner has claim to a portion of the earnings, if any, after all the debt instrument holders are paid.
Combination instruments: these are the financial instruments which have characteristics of both the debt and equity instruments. Examples would include preferred stocks and convertible bonds.
Characteristics of Debt Instruments
Debt instruments include loans, money market instruments, bonds, mortgage-backed securities, and asset-backed securities. Certain features which are common to all the debt instruments are described below.
Maturity: the term to maturity if defined as the number of years/periods over which the issuer has promised to meet the conditions of the debt obligations.
Money market instruments are those debt instruments which have a maturity of less than a year and those above a year are called capital market debt instruments.
Par Value: the par value of a bond is the amount which the issuer agrees to repay the holder of the debt instrument by the maturity date. This is also called principal, face value, redemption value, or maturity value.
Coupon Rate: it is the interest rate that the issuer agrees to pay each year/period. It is also called nominal rate or coupon rate. The actual frequency of the payment depends upon the features of the instrument and is announced when the instruments is up for sale.
Zero-Coupon Bonds: these are the debt instruments which do not make a periodic payment before the maturity date. The bonds are available at a price below the par value and the interest earned is the difference between the amount paid and the par value.
Accrued coupon instruments/accrual securities/compound interest securities – these are similar to zero coupon bonds, though here the issuer has the contractual obligation to pay coupon interest. The coupon payments are accrued and are distributed along with the maturity amount.
Floating rate securities: these are the debt instruments which have their coupon rate adjusted periodically on a predetermined reference rate. They are called floating-rate securities or floaters or variable-rate securities. The typical formula for the same would be
Reference Rate ± Quoted Margin
where quoted margin would be the additional amount that the issuer agrees to pay above or below the reference rate and is expressed in terms of basis point. (It would suffice as of now to know that 1 basis point is 100th of a 1% value).
The inverse floaters are those debt instruments where the coupon rate decreases with increase in reference rate. These are also called reverse floaters.
Payments
Bullet maturity: the bonds which have a single payment at maturity and no interim payments are made.
Sinking fund requirement: when an issuer is required to pay a portion of the issue each year then it is called so. The instruments following this principle are called amortising instruments.
Call and refunding provisions
Call provision gives the liberty to the issuer to retire a part or whole of the debt before its maturity. There are number of risks faced by the investor here and would be outlined later. The price which the issuer pays to retire the issue (in part or whole) is called the call price. The first date on which the call provision can be exercised is called first call date. Some instruments have a provision by which the issue cannot be called before a certain amount of time has passed. These instruments are said to have a deferred call. If such provisions do not exist, the issue is called currently callable issue.
The instruments having call provision are also said to be having prepayment provisions where the issuer can retire the part or whole of issue before the scheduled date.
Refunding a bond issue would mean refunding a bond issue with the proceeds from the sale of another bond issue. This is risky for the investor because as the interest rates would fall the issuer would retire the issue with the proceeds from the sale of another issue at a lower coupon rate. The initial investors would now be faced with reinvestment risk as they have to reinvest the money into a lower coupon debt instrument.
Put provision: when the investor has the right to get the issue redeemed at a predetermined price and time, prior to the maturity date, it is said to possess the put provision. The price at which the issue can be sold back is the put price.
Convertible debt instrument: this is an instrument which grants the investor the right to convert or exchange the debt instrument for a specified number of shares of common stock of the company.
Assuming the basic characteristics (maturity, coupon rate, par value) to be same, the issue with a call provision/refunding provision would sell for greater price as compared to instruments having put/convertibility provision. The reasons are obvious, because the call/refunding provision exposes the investor to reinvestment risks, and the put/convertibility provision gives the investor the right to adjust the investment as suitable thereby protecting him/her from excess risks.
Valuation of a Financial Instrument
Valuation is the method of determining the fair value of the financial instrument. There are three possibilities in determining the merits of the instrument with respect to the market price (price at which the instrument is available to be bought):
If FP>MP, the instrument is under-priced,
If FP<MP, the instrument is overpriced,
If FP=MP, the instrument is fairly priced.
Financial market is the place where the financial instruments are traded. The financial market where the financial assets trade for immediate delivery is called spot market.
The financial markets serve 3 distinct economic functions given as:
· Price discovery process – here the buyer and seller come together to determine the price at which they would trade, thus the market price of the financial asset is determined at the exchange
· Liquidity to the investor – the investor can trade the financial asset, thereby liquidating the same
· Reducing cost of transaction – the search costs which refers to the cost of finding a buyer/seller as need be, and the information cost of analysing and determining the fair price of the instrument are reduced by the exchange. This is based on the belief that the markets are efficient.
The financial markets can be categorised into different ways as given below:
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